Economic Logic, Too

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I discuss recent research in Economics and various events from an economic perspective, as the name of the blog indicates. I plan on adding posts approximately every workday, with some exceptions, for example when I travel.

Wednesday, January 29, 2014

IS-LM models have always left me puzzled. To me, they are the equivalent to a reduced-form regression with omitted variables and endogeneity issues. Through a lot of hand-waving, you can have any model fit the data. But what I find the most bizarre is this strange obsession with justifying the IS-LM models from micro-foundations. Somehow, IS-LM is taken as an ultimate truth, and one needs to reverse-engineer it to find what can explain it. The ultimate truth is the data, not the model.

Pascal Michaillat and Emmanuel Saez bring us yet another paper that tries to explain the IS-LM model from some set of micro-foundations. The main ones this time are money-in-the-utility-function and wealth-in-the-utility function (and matching frictions on the labor market, which are not objectionable). I find it very hard to believe that by now anybody would consider this a valid starting point. Rarely does anybody enjoy simply having money, the reason why people like having money is that they can buy things with it, things that are already in the utility function, or that money facilitates transactions, something that you can easily model. The same applies to wealth. True, some people may be obsessed with getting richer just for being rich, but for the remainder of the citizen, they like wealth for what it brings in future consumption for themselves and their heirs, and for the security it brings in the face of future shocks. All this easily modelled in standard models.

It seems to me this paper is a serious step back. Macroeconomists try to understand why there are frictions on markets, so that one better determine the impact of policy on such markets. Simply sweeping everything in the utility function, where in addition one has a lot of freedom in choosing its properties, does not help us in any way. And it is wrong, because it is again some sort of reduced form that is not immune to policy changes. Suppose the economic environment becomes more uncertain. Are we now supposed to say that suddenly households like wealth more? They could also like wealth more because of changes in estate taxation or because of longer lifetimes, and these imply very different policy responses in better flushed-out models.

If you don't value having money in your wallet, then why do you hold money in your wallet? I bet it's because you need it to buy things? Perhaps because bartering is impractical? You should try to barter for everything for a day and see if you derive any disutility...

But the point of using MIUF in this case is that MIUF is a standard way Macro people model money, and so the point of the paper was that you can get IS/LM from more-or-less standard-looking macro models with frictions.